What price is right for a low carbon future

Australia’s lower house of Parliament passed a carbon tax yesterday. It prices carbon at $23 a ton. India’s carbon tax is 80 rupees (about $1) a ton. So what is the appropriate price of carbon? According to Robert Litterman in his Financial Analysts Journal editorial, it is a complex equation that should reflect fundamental uncertainty about catastrophic risks and a high level of societal risk aversion.

Most governments that have taken early action, relative to their global peers, have been met with much criticism, partly I believe because the US is not pricing carbon at all. For this those countries, such as Australia, should be applauded. I for one like governments, and any leaders, to lead.

But it is not just governments that can act to educate the public. As Litterman points out, investors are experienced in pricing unknown risks, and so are a natural constituency to educate the public on the benefits of pricing emissions.

He says in the case of carbon emissions that the risk premium for increased exposure to unknown risks is clearly not being set appropriately. And with regard to climate change, society cannot afford to wait and see whether truly catastrophic outcomes will result.

“Because the known and unknown risks of catastrophic consequences are significant, the risk premium for increased emissions today should reflect those risks,” he says.

The price of carbon, Litterman contends, can be related to the equity risk premium puzzle.

“The appropriate price for carbon emissions depends critically on how risk-averse a society is,” he says.

Until recently, economists assumed that society had a very high tolerance for risk.

The typical “reasonable” risk-aversion assumption used by economists would imply an equity risk premium in the range of 13-19 basis points, not the 600-800 basis points that has been seen in equity markets historically, he says.

“In recent years, the combination of the recognition of uncertainty in worst-case outcomes and the need to incorporate risk aversion realistically has had a powerful impact – namely, to raise the appropriate price of emissions significantly,” he says.

What this means, he says, is the appropriate price for carbon emissions is much higher than the values in earlier studies that assumed higher risk tolerance.

He explains that the reason economists typically assumed very high levels of risk tolerance has to do with the use of the constant relative risk aversion (CRRA) utility, which captures two aggregate economic behaviours. The first is inter-temporal substitution (try convincing a six-year-old to forgo eating chocolate now for more chocolate in the future!), and the second is risk aversion.

“The rigidity of CRRA utility is also a serious problem in climate economics because inter-temporal substitution and risk aversion are key determinants of the appropriate price for carbon emissions, which when emitted today create increased risk in the distant future,” he says.

While Litterman does not suggest an appropriate price for carbon, he does say “we do know that it is significant”, citing a recent US Government study (US Interagency Working Group on Social Cost of Carbon) that suggested a range of values centred on $21 per metric ton of carbon dioxide.

As with all matters of politics, it is up to governments to explain to an uninterested public the rationale for their price. And while it is complex, there is an opportunity for investors, with their experience of pricing unknown risks, to play a part in that education.